Alistair Darling/Addendum

The financial crisis

When Alistair Darling took office as Chancellor of the Exchequer in June 2007, the international financial system had just entered the first stage of the financial crisis. A sharp and unexpected fall in United States house prices had created the subprime mortgage crisis by causing large falls in the prices of internationally-held securities whose value depended upon mortgages secured on those houses. British banks were known to be affected, and it was realised that their losses could be expected to have an adverse effect on other sectors of the economy. The crisis entered its second stage in August 2007, when the French BNP Paribas bank announced that it could not determine the value of those of its bonds that were backed by US house mortgages. A mood of uncertainty developed in which every financial institution experienced doubts, not only about its own holdings, but also about the securlties held by its trading partners. That uncertainty deprived some banks of their accustomed sources of loans, and placed some of them in danger of insolvency. (One such was Northern Rock). That was the situation faced by Alistair Darling at the time of his first budget in March 2008. By October, however, the situation had changed. The catastrophic third stage of the crisis had been triggered by the insolvency of one of the world's largest investment banks, Lehman Brothers and the writeoff of $785bn worth of its issued funds. Uncertainty had changed to panic, with banks and others refusing to lend to each other, or to commercial borrowers; and the financial system seemed to be in imminent danger of total collapse.

Fiscal deficits

The effect of the financial crisis was to deprive firms of the ability to finance their activities by borrowing or by the roll-over of debt due for repayment, and so bring about a reduction in economic activity and an increase in unemployment. A rise in the government's budget deficit follows because lower activity leads to lower tax revenues and more unemployment leads to increased benefit payments. Because it destroyed some of the country's production capacity, the following Great Recession added to the pre-existing or "structural" deficit as well as creating a "cyclical" deficit which will disappear when the utilisation of the surviving capacity returns to normal.

According to estimates by the Institute of Fiscal Studies, the United Kingdom entered the recession in 2007-8 with a relatively small structural deficit of around 2 per cent of GDP, which the recession had extended to 6 per cent during the financial year 2009-10, and to which was added a cyclical deficit of about 4 per cent of GDP and a discretionary fiscal stimulus of nearly 2 per cent, to make a total approaching 12 per cent of GDP However, as the Institute's authors add, "borrowing as high as 6% of national income permanently would have left debt on an unsustainable upward path".